Option Overwriting

7/28/2019 Option Overwriting

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Chapter 18

Option Overwriting


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Whats a good way to raise the blood pressure of an

Investor Relations Manager? Answer: Talk aboutthe pros and cons of stock options.

- Eilene H. Kirrane


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Outline Introduction

Using options to generate income

Combined hedging/income generation

strategies

Multiple portfolio managers


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Introduction Option overwritingrefers to creating and

selling stock options in conjunction with a

stock portfolio

Motives for overwriting:

To generate additional portfolio income

To purchase or sell stock at a better-than-market price


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Using Options to

Generate Income Writing calls to generate income

Writing puts to generate income

Writing index options

A comparative example


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Writing Calls to

Generate Income Writing covered calls

Writing naked calls


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Writing Covered Calls Writing covered calls:

Occurs when the investor writes options against

stock he already owns Is the most common use of stock options by

both individual and institutional investors

Has a profit or loss determined by the long

position and the short position


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Writing Covered Calls (contd) Covered call writing is very popular with

foundations, pension funds, and other

portfolios that need to produce periodiccash flows

In relatively stable or slightly decliningmarkets, covered call writing can enhanceinvestment returns


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Writing Covered Calls (contd)Example

Nile.com stock currently trades for $116 per share. Calloptions with a striking price of $120 and a $6 premiumare available for Nile.com.

Construct a worksheet and a profit and loss diagram to

determine the profit or loss associated with writing acovered call for Nile.com. Assume the investor purchasesthe stock for $116. Use a range for the stock price atoption expiration from $0 to $150.


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Writing Covered Calls (contd)Example (contd)

Solution: A possible worksheet is shown below:

+10+10+10+6-10-60-110Total

-24+1+6+6+6+6+6Short call

+34+9+40-16-66-116Long stock

150125120116100500

Stock Price at Option Expiration


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Writing Covered Calls (contd)Example (contd)

$0

-$110

$10

$120

Maximum gain

Maximum loss


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Writing Naked Calls Writing naked calls:

Involves writing an option without owning the

underlying stock Has a potentially unlimited loss

Especially if the writer must buy the shares in the

market

Is used by institutional heavyweights to make

money for their firm


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Writing Naked Calls (contd)Naked call writing is not often used by

individual investors

Brokerage houses may enforce high minimumaccount balances

Fiduciaries should be extremely carefulabout writing naked calls for a client


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Writing Puts to

Generate Income Fiduciary puts

Put overwriting


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Fiduciary Puts Afiduciary putis a covered (short) put

The writer of a fiduciary put must depot the

striking price of the option in an interest-bearing account or hold the necessary cash

equivalents

The commission costs of fiduciary puts may

be lower than writing covered calls


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Fiduciary Puts (contd)Example

February put options on Nile.com are available with anexercise price of $120 and an option premium of $7.25.

Construct a profit and loss diagram for a fiduciary put,

showing the maximum gain and maximum loss.


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Fiduciary Puts (contd)Example (contd)

$0

-$112.75

$7.25

$120

Maximum gain

Maximum loss


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Put OverwritingPut overwriting:

Involves owning shares of stock and writing put

options against them Is a bullish strategyBoth owning shares and writing puts are bullish

strategies

May be appropriate for portfolio managers whodont want to write calls for fear of opportunitylosses


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Put Overwriting (contd)Example

An investor buys Nile.com stock for $116 per share.Simultaneously, the investor writes a Nile.com FEB 115put with an option premium of $4.25 per share.

Construct a worksheet and a profit and loss diagram to

determine the profit or loss associated with putoverwriting. Use a range for the stock price at optionexpiration from $0 to $150.


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Put Overwriting (contd)Example (contd)

Solution: A possible worksheet is shown below:

+38.35+4.25+3.25-76.75-226.75Total

+4.25+4.25+4.25-35.75-110.75Short put+340-1-41-116Long stock

150116115750

Stock Price at Option Expiration


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Put Overwriting (contd)Example (contd)

$0

-$226.75

$115

Maximum gain

is unlimited

Maximum loss


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Writing Index Options Introduction

Margin considerations in writing index call

options Using a cash account

Using a margin account

The risk of index calls

What is best?


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IntroductionIndex options:

Are one of the most successful innovations of

all time

Include the S&P 100 and S&P 500 index

options

Have little unsystematic risk


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Margin Considerations in

Writing Index Call Options Using a margin account does not

necessarily involve borrowing

Charitable funds or fiduciary accounts use

margin accounts to provide the fund

manager with added flexibility


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Using A Cash Account A portfolio manager can use a cash account to

write index options:

If a custodian bank issues an OCC index option escrow

receipt to the broker

If the bank certifies that it holds collateral sufficient to

cover the writing of index calls and

If the writer can provide the necessary collateral by the

deposit of cash, cash equivalents, marginable stock, or

any combination of these


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Using A Margin Account The required funds in a margin account to write

index calls:

Equal the market value of the options plus 15% of the

index value times the index multiplier less any out-of-

the-money amount and

Are subject to a minimum amount equal to the market

value of the options plus 10% of the market value of the

index times the index multiplier


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Forms of Margin

(Margin Equivalents)


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The Risk of Index Calls The risk of writing index calls is that the

index will rise above the chosen exercise

price

The lower the striking price:

The more income the portfolio receives

The higher is the likelihood that the option endsup in the money


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The Risk of

Index Calls (contd) Cash settlementprocedures for in-the-

money index options:

Involve the transfer of cash rather thansecurities

The writer owes the call holder the intrinsicvalue of the call at option expiration


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The Risk of

Index Calls (contd)Example

A portfolio manager wrote 90 FEB 690 OEX calls. On theexpiration date, the S&P 100 index is at 693.00.

What is the amount the portfolio manager must pay to the

holder of the OEX options?


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The Risk of

Index Calls (contd)Example

Solution: The manager must pay $27,000:

(693.00 690.00) x $100 x 90 contracts = $27,000


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What Is Best? Advantages of writing index options over

writing calls on portfolio components:

They require only a single option position They vastly reduce aggregate commission costs

They carry much less unsystematic risk

There is less disruption of the portfolio whencalls expire in-the-money and are exercised


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A Comparative Example Setup

Covered equity call writing

Covered index call writing

Writing fiduciary puts

Put overwriting

Risk/return comparisons


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Setup Consider three market scenarios:

An advance of 5%

No change A decline of 5%

We are managing a portfolio of five stocks(see next slide)


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Covered Equity Call Writing Individual call options are written against

each of the five securities in the portfolio

The following slide shows the managers

selection of options and the resulting

performance


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Covered Equity

Call Writing (contd) Observations:

The portfolio makes money in each of the

scenarios The portfolio makes the most money when the

market advances

The portfolio would lose all five securities

ARC and IP are called away when the market

remains unchanged


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Covered Index Call Writing Covered index calls are written

The following slide shows the managersselection and performance


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Covered Index

Call Writing (contd) Observations:

The greatest gain occurs when the market

advances 5%

The manager does not have to sell any stocks

because of cash settlement


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Writing Fiduciary Puts Index put options are written in anticipation

of the underlying stock rising in value

The following slide shows the selection of

puts and the resulting performance


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Put Overwriting Put overwriting is the most aggressive

strategy

The following slide shows the selection of

puts and the resulting performance


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Risk/Return Comparisons

Put overwriting has the largest potential

losses and gains

Writing covered equity calls is not always

superior to writing covered index calls


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Risk/Return

Comparisons (contd)


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Combined Hedging/Income

Generation Strategies

Writing calls to improve on the market

Writing puts to acquire stock

Writing covered calls for downsideprotection


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Writing Calls to

Improve on the Market

Appropriate for someone who wants to sell

shares of a stock but has no immediate need

for the money Income can be increased by writing deep-

in-the money calls

The writer attempts to improve on the market The expectation is that the calls will be

exercised


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Writing Calls to Improve on

the Market (contd)

Example

Nile.com stock currently sells for $116 per share. An

institution holds 1,000 shares and would like to sell thestock. JAN 100 calls on Nile.com are available for $18 pershare.

If the stock price on the expiration is $120, what would bethe cash receipts to the institution if it writes 10 calls andsells the stock in January? What would be the cashreceipts if it sold the stock today?


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Writing Calls to Improve on

the Market (contd)

Example (contd)

Solution: If the institution sells the shares immediately, it

would receive $116,000 (1,000 shares x $116).

If it wrote 10 calls, it would receive $118,000 in January:

Option premium:

$18 x 100 x 10 = $18,000

Stock sale when options are exercised:

$100 x 1,000 shares = $100,000


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Writing Puts to Acquire Stock

Involves writing in-the-money put options

A manager can improve on the market bypurchasing the stock when the put options

are exercised


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Writing Puts to

Acquire Stock (contd)

Example

You want to buy 500 shares of Western Oil, which

currently trades at $66.75 per share. January 70 puts sells

for $5.

What is the cost of acquiring the shares now? What is the

cost of acquiring the shares if you write 5 WO JAN 70

puts and the options are in-the-money on the expiration

day?


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Writing Puts to

Acquire Stock (contd)

Example

Solution: Outright purchase of the shares now would cost

$33,375 (500 shares x $66.75).

If you write 5 puts, you would pay $32,500 for the shares:

Option premium received:

5 x 100 x $5 = $2,500Amount paid for shares when options are exercised:

5 x 100 x $70 = $35,000


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Writing Covered Calls

for Downside Protection

Appropriate for an investor who: Owns shares of stock

Suspects the market will turn down in the near future

Does not want to sell the shares at the moment

Provides some downside protection, butalternatives are: Buying puts

Using portfolio insurance


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Multiple Portfolio Managers

Separate responsibilities

Distinction between option overwriting and

portfolio splitting Integrating options and equity management


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Separate Responsibilities

Assume:

A stock portfolio is assembled by a manager for

a client The stock portfolio is used by a different

manager for writing covered options

Management of the stock portfolio is the

most important concern


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Option Overwriting

Versus Portfolio Splitting

Portfolio splittingmeans managing a

portfolio in accordance with more than one

objective E.g., half is growth of income, half is capital

appreciation

Option overwriting seeks to generate

additional profits for the fund through the

receipt of option premiums


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Integrating Options

and Equity Management

Hedging company-specific risk

Unity of command


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Hedging

Company-Specific Risk

To hedge a company-specific risk of a

particular firm in a portfolio use individual

equity options To hedge industry risk, employ options on

an industry index

To hedge the entire portfolio, use indexoptions


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Unity of Command

Index options increase the feasibility ofusing a single portfolio manager for bothequity and option positions

Index options do not require the transfer ofsecurities

The time requirement to overwrite with index

options is minimal The manager who has the flexibility of index

options can exercise more creativity

Option Overwriting

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